Proctor & Gamble is engaged in the business of manufacturing and marketing of consumer and industrial products. Proctor & Gamble operates through domestic (US) and foreign subsidiaries and affiliates.
Proctor & Gamble owned all the stock of Procter & Gamble A.G. (AG), a Swiss corporation. AG was engaged in marketing Proctor & Gamble’s products, generally in countries in which Proctor & Gamble did not have a marketing subsidiary or affiliate.
Proctor & Gamble and AG were parties to a License and Service Agreement, known as a package fee agreement, under which AG paid royalties to Proctor & Gamble for the nonexclusive use by AG and its subsidiaries of Proctor & Gamble’s patents, trademarks, tradenames, knowledge, research and assistance in manufacturing, general administration, finance, buying, marketing and distribution. The royalties payable to Proctor & Gamble were based primarily on the net sales of Proctor & Gamble’s products by AG and its subsidiaries. AG entered into agreements similar to package fee agreements with its subsidiaries.
In 1967, Proctor & Gamble made preparations to organize a wholly-owned subsidiary in Spain to manufacture and sell its products in that country. Spanish laws in effect at that time closely regulated foreign investment in Spanish companies. The Spanish Law of Monetary Crimes of November 24, 1938, in effect through 1979, regulated payments from Spanish entities to residents of foreign countries. This law required governmental authorization prior to payment of pesetas to residents of foreign countries. Making such payments without governmental authorization constituted a crime. Decree 16/1959 provided that if investment of foreign capital in a Spanish company was deemed economically preferential to Spain, a Spanish company could transfer in pesetas “the benefits obtained by the foreign capital.” Proctor & Gamble requested authorization to organize Proctor & Gamble Espana S.A. (Espana) and to own, either directly or through a wholly-owned subsidiary, 100 percent of the capital stock of Espana. Proctor & Gamble stated that its 100 percent ownership of Espana would allow Espana immediate access to additional foreign investment, and that Proctor & Gamble was in the best position to bear the risk associated with the mass production of consumer products. Proctor & Gamble also indicated that 100 percent ownership would allow Proctor & Gamble to preserve the confidentiality of its technology. As part of its application, Proctor & Gamble estimated annual requirements for pesetas for the first five years of Espana’s existence. Among the items listed was an annual amount of 7,425,000 pesetas for royalty and technical assistance payments. Under Spanish regulations, prior authorization of the Spanish Council of Ministers was required in order for foreign ownership of the capital of a Spanish corporation to exceed fifty percent.
The Spanish government approved Proctor & Gamble’s application for 100 percent ownership in Espana by a letter dated January 27, 1968. The letter expressly stated that Espana could not, however, pay any amounts for royalties or technical assistance. For reasons that are unclear in the record, it was determined that AG, rather than Proctor & Gamble, would hold 100 percent interest in Espana.
From 1969 through 1979, Espana filed several applications with the Spanish government seeking to increase its capital from the amount originally approved. The first such application was approved in 1970. The letter granting the increase in capital again stated that Espana “will not pay any amount whatsoever in the concept of fees, patents, royalties and/or technical assistance to the investing firm or to any of its affiliates, unless with the approval of the Administration.” All future applications for capital increases that were approved contained the same prohibition.
In 1973, the Spanish government issued Decree 2343/1973, which governed technology agreements between Spanish entities and foreign entities. In order to obtain permission to transfer currency abroad under a technology agreement, the agreement had to be recorded with the Spanish Ministry of Industry. Under the rules for recording technology agreements, when a foreign entity assigning the technology held more than 50 percent of the Spanish entity’s capital, a request for registration of a technology agreement was to be looked upon unfavorably. In cases where foreign investment in the Spanish entity was less than 50 percent, authorization for payment of royalties could be obtained.
In 1976, the Spanish government issued Decree 3099/1976, which was designed to promote foreign investment. Foreign investment greater than 50 percent of capital in Spanish entities was generally permitted, but was conditioned upon the Spanish company making no payments to the foreign investor, its subsidiaries or its affiliates for the transfer of technology.
Espana did not pay a package fee for royalties or technology to AG during the years at issue. Espana received permission on three occasions to pay Proctor & Gamble for specific engineering services contracts. The Spanish Foreign Investments Office clarified that payment for these contracts was not within the general prohibition against royalties and technical assistance payments. Espana never sought formal relief from the Spanish government from the prohibition against package fees.
In 1985, consistent with its membership in the European Economic Community, in Decree 1042/1985 Spain liberalized its system of authorization of foreign investment. In light of these changes, Espana filed an application for removal of the prohibition against royalty payments. This application was approved, as was Espana’s application to pay package fees retroactive to July 1, 1987. Espana first paid a dividend to AG during the fiscal year ended June 30, 1987.
The Commissioner determined that a royalty of two percent of Espana’s net sales should be allocated to AG as royalty payments under section 482 for 1978 and 1979 in order to reflect AG’s income. The Commissioner increased AG’s income by $1,232,653 in 1978 and by $1,795,005 in 1979 and issued Proctor & Gamble a notice of deficiency.1 Proctor & Gamble filed a petition in the Tax Court seeking review of the deficiencies.
The Tax Court held that the Commissioner’s allocation of income was unwarranted and that there was no deficiency. The court concluded that allocation of income under section 482 was not proper in this case because Spanish law, and not any control exercised by Proctor & Gamble, prohibited Espana from making royalty payments.
Decision of the U.S. Court of Appeals for the Sixth Circuit
The Commissioner argues that the Tax Court erred by refusing to apply Treas.Reg. § 1.482-1(b)(6), the “blocked income” regulation. Treas.Reg. § 1.482-1(b)(6) provides in pertinent part:
“If payment or reimbursement for the sale, exchange, or use of property, the rendition of services, or the advance of other consideration among members of a group of controlled entities was prevented, or would have been prevented, at the time of the transaction because of currency or other restrictions imposed under the laws of any foreign country, any distributions, apportionments, or allocations which may be made under section 482 with respect to such transactions may be treated as deferrable income.”
“This regulation recognizes the problem posed by restrictions placed on payments in a foreign currency. Income allocated under section 482 may be deferred if payments have been blocked by currency or other restrictions under the laws of a foreign country. The Tax Court determined that because section 482 did not apply to the present case, the regulations promulgated under section 482 likewise did not apply.”
“The Commissioner argues that this regulation is designed to remedy the situation presented in this case. We disagree. Treas.Reg. § 1.482-1(b)(6) contemplates the situation where a temporary restriction under foreign law prevents payments, and defers the allocation of income until such time as the payments are no longer restricted. This case does not present a situation in which payments to P & G were temporarily restricted; rather, Spanish law prohibited payment of royalties altogether. This prohibition cannot be viewed as temporary because it was ultimately repealed in 1987. At the time in question, there was no reason for P & G to believe that the Spanish government would lift this ban; therefore, the payments that Espana was prohibited by law from making cannot be viewed as temporarily blocked payments.”
“The Commissioner also argues that the prohibition on royalty payments was temporary and that P & G could have deferred royalty payments under this regulation and then at some future time P & G could have liquidated Espana and taken its capital out of Spain. Upon liquidation, the Commissioner argues, the temporary prohibition on payment of pesetas would end. We find this argument to be meritless because P & G need not organize its subsidiaries in such a way as to maximize its tax liabilities. There is no question that P & G may legally structure its affairs in its own best interest. Salyersville, 613 F.2d at 653. We agree with the Tax Court that Treas.Reg. § 1.482-1(b)(6) does not apply to this case.”
“Accordingly, the decision of the Tax Court that allocation of income under section 482 is inappropriate is AFFIRMED.”
Note that in July of 1994 the IRS issued new regulations that would substantially alter this outcome for future cases.